UNFAIR VALUE

“9 crores! To hell with you…” I realized I had miscounted one zero. That 3,100 sq. ft. apartment, which I thought as priced at 90 lakhs, was actually selling at 9 crores. “That’s unfair. With such rates they are pricing out even reasonably successful people.” I was furious....trying to come to terms with the reality of realty. “29,000 per sq. ft. … Damn!” The number sounded familiar. It was same as the height of Mt. Everest (29,002 ft.). I couldn’t help smiling.

But was that price unfair? The seller of the apartment was selling at a price that he thinks as the fair value of the asset. Who am I to decide what price should someone ask when he sells his asset? No one is forcing me to enter into an unfair transaction. If I get more value for the price I pay, I buy. Otherwise, I walk away.

It is a plain common sense. As an investor you can’t afford to overlook this, and if you do then you can’t stake a claim to rationality. However, people do it all the time. They make foolhardy decisions even when the odds are staring them in the eye. That makes me agree with the proverb that common sense is the rarest sense.

There must be more to an otherwise rational person taking a stupid call despite the odds being stacked against him. But really, what on earth would make you and I (starting with the premise that we both are rational individuals) ‘happily’ fork out nine crores for that ‘coveted’ apartment?

This places before us a difficult question – how to ascertain fair value of a given asset. The assets, which derive their value mainly from the future earning stream, like stocks, are even harder to appraise. To be able to put a value to a company, you have to predict the future cash flows, the trends in long-term interest rates and the associated risks. There are not only many unknowns in the equation but many unknowables too. Any investment advisor, who tells you a stock’s target price, is not only fooling the people whom he advises, but also himself.

If that is true, how should an investor decide what price to pay for an asset? The answer lies in estimating the value to the best of your abilities and leaving a margin of safety. If you buy at a price 50% below your rough estimate of the value of the stock, you would still do fine if you overestimated the value by 20%. The concept of ‘margin of safety’ is not new. Civil engineers for example, build bridges to withstand far greater stress than the stress under peak load conditions. An adult female cod fish is keeping that margin of safety against predation when it produces 4–6 million eggs: It knows that very few eggs will survive to hatch, and very few hatchlings will live long enough to reach the reproductive age. The extra eggs guarantee that even in worst case enough fish will survive. (The mathematics of best case is even more interesting#).

This common approach to investing is called value investing. The framework of value investing was laid out by Benjamin Graham in his classic works on investing, such as ‘The Intelligent Investor’ and ‘Security Analysis’. His ideas have stood the test of time and their relevance has been proven by the superior returns achieved by the value investors over long periods of time. Ask Warren Buffett, who became world’s richest with 21.1% p.a. compounded for 42 years. And he is not alone, read his speech “The Superinvestors of Graham-and-Doddsville” delivered on Graham’s centenary celebration, where he lists many more value investors who achieved equally spectacular returns by following value investing principles.

Among all classes of securities, stocks offer rich pickings for the investors who learn and methodically follow the value investing approach. A stock is not a piece of paper whose price changes at the whims and fancies of speculators. It is a share of a business, backed by some assets and future earning streams. Owning a stock is, owning a business, howsoever miniscule your stake may be. That means when you plan to buy a stock you have to think like a potential owner of the business.

Suppose a genie comes out of a bottle and offers to give you one million worth of stock of any one company of your choice. The freebie comes with a rider – you cannot sell the stock until the next 50 years. What attributes would you look for in the company you choose? You would want to invest in a company you understand. You would want to invest in a company that has sustainable competitive advantage over its competitors. You would want to invest in a company that would still be around 50 years later. You would want to invest in a company that is not priced too high compared to its assets and earnings. Better still, as a ‘value investor’ you would like to pocket bag the company when it’s being offered at a throwaway price. This extreme case brings out exactly the same qualities that you should look for when you invest in a stock.

As the name suggests, Unfair Value, relishes the unfairness of the game. Unfair Value is aimed at helping you invest at a price that gives you unfairly high value for the price you pay; to invest at the times when the odds are unfairly skewed in your favor.

If you care about fairness, you should stay away from stock markets. You can try your luck playing Baccarat in Macau or, why go that far, tossing a coin would give you the same odds. Find someone to play with you…No… not me! I prefer the heads-I-win, tails-you-lose games.

# In 1873, Alexandre Dumas wrote: "It has been calculated that if no accident prevented the hatching of the eggs and each egg reached maturity, it would take only three years to fill the sea so that you could walk across the Atlantic dryshod on the backs of cod."

The post seems to be what once Seema and myself were discussing and I felt that it was just a thought. after reading you post it seems to b a good effort.goodluck to you and seema. I am sure the teaming would bring good and effective results in desired areas.best of luckbe sincere.RegardsAnurag

Hi Kamlesh,Though your first blog started pretty well, it became pretty routine after the first para. It pretty much goes on the same/expected lines as what one would have found in any one has read on warren buffet or related books including the books you mention in the blog.I am not sure who the blog has been directed to, but if anyone has joined the yahoo group it can be assured he/she might have made an attempt to read through the relevant books(atleast the majority).I have a suggestion here for you since you have obviously read widely. How about formulating the principles of Graham so that even a beginner could use those principles. The email you wrote recently on the yahoo group on book value was awesome. Similarly simple principles/formulae on picking stocks the graham way will be something will be much appreciated! Regards!